If you provide services to small business clients, chances are you have clients that own a business jointly with a spouse. Often spouses share ownership of their business equally, and at least in their own minds, consider themselves to be “one unit”. As ProAdvisors, we should be aware of a few entity classification issues that relate specifically to married business owners.
Prior to 2007, spouses who both worked in a family business as co-owners, had equal say in the affairs of the business, provided substantially equal services to the business, and both contributed capital to the business, were considered to be partners in a partnership. Such spouses were required to file a partnership return for the business, but this requirement was often overlooked.
Then, effective for taxable years beginning after Dec 31, 2016, the Small Business and Work Opportunity Tax Act of 2007 created the concept of a “qualified joint venture” (QJV), with a provision that a partnership return was NOT required to be filed for a QJV. According to IRS Publication 541, a qualified joint venture is defined as a trade or business in which (1) the only members of the joint venture are a husband and wife, (2) both spouses materially participate in the trade or business, and (3) both spouses elect to have the provision apply. The election is easy to make, as each spouse is simply required to report their share of the profit from the business on a separate schedule C. The reported share of profit must accurately reflect each spouse’s respective interest in the venture.
Over time, the IRS has clarified the definition of a QJV. On the IRS.gov website, you can search for “Election for Husband and Wife Unincorporated Businesses” to find a discussion of this topic. On that website, it is explained that “a qualified joint venture…includes only businesses that are owned and operated by spouses as co-owners, and not in the name of a state law entity (including a limited partnership or limited liability company)” (1). Therefore, if spouses as joint owners take advantage of the limited liability protection that an LLC provides, they are no longer eligible to make an election as a QJV.
In my personal experience, this part of the QJV rules is not well known, and as a result, we see a number of clients who have not filed the required partnership tax returns for jointly owned LLCs. When spouses establish an LLC under state law, assuming they are aware of the QJV rules at all, they often make the mistake of reporting the business income on separate schedules C, when in fact they are not eligible to do so.
There is one additional wrinkle to consider. The treatment of an LLC owned by spouses can change depending upon the state the spouses live in. If they reside in a community property state, that legal concept may operate to change the classification of an LLC for tax purposes. Rev. Proc. 2002-69 addresses the issue of classification for an entity that is solely owned by husband and wife as community property, such that it is possible in some circumstances to continue to treat the jointly owned LLC as a disregarded entity for tax purposes, thus eliminating the requirement for a partnership return in that case.(2)
Overall, guidance about to how to classify an LLC owned by spouses is available, so as ProAdvisors, we can raise awareness of the issue, and help our clients to get it right.
Kristin Shea, CPA
Owner, K Shea CPA, LLC
Kristin Shea is the owner of K Shea CPA, LLC (www.ksheacpa.com) in Athens, GA. The firm has been helping to lift the burdens of small business owners since 2008, including proactively advising on start-up operations and compliance responsibilities.